Overdraft Rules Mean Consumers Will Pay Up, or Get Out (Update 1)

Updated with additional comment from Frank Mayer, a partner in the Financial Services Practice Group of Pepper Hamilton.

NEW YORK (TheStreet) -- The Consumer Financial Protection Bureau's new focus on overdraft fees will cause banks to strengthen their most profitable customer relationships, while cutting loose consumers that continue to drain the bottom line, according to industry analysts.

"It costs between $100 and $120 a year to maintain a checking account for your customer," says FBR analyst Paul Miller. " My guess is they will go back to the old days, and these guys are not going to provide free products. They will either push you out the door, or find a way to charge you."

Consumer Financial Protection Bureau Director Richard Cordray

The Consumer Financial Protection Bureau, or CFPB, on Wednesday announced that it had "launched an inquiry into checking account overdraft programs to determine how these practices are impacting consumers," with Director Richard Cordray saying that "overdraft practices have the capacity to inflict serious economic harm on the people who can least afford it."

The CFPB said that a study by the Federal Deposit Insurance Corporation found that consumers who overdrew 20 or more times per year paid an average of $1,610 in overdraft fees annually." Cordray requested comment on a new "penalty fee box" disclosure statement, that would make it easier for consumers to understand just how much they were paying in overdraft fees.

Of course, one would think that a depositor would realize if they were hit with heavy overdraft fees, but clear disclosure is always a good thing.

But there were several hints in the CFPB release that the big banks are looking at another money grab, justified by the "disproportionate Impact on low-income and young consumers," with "46.4 percent of young adult accountholders having incurred overdraft fees," according to a 2008 FDIC study, while "of those, 15 percent recorded more than ten overdrafts in one year."

The CFPB's "What's your overdraft status?" campaign to educate consumers on overdraft fees, may also have an impact on bank revenues, although it would seem that the high fees are already obvious to consumers.

The banks famously took a huge hit to revenue, beginning in August 2010, when the Federal Reserve's new "opt-in" rules went into effect, requiring banks only to provide overdraft protection for ATM or debit card transactions for customers who previously signed up for the service.

Bank of America , for example, reported service charges on deposit accounts totaling $1.3 billion during the fourth quarter of 2010 -- the first full quarter of the "opt-in" rule" -- which was a 36% decline from a year earlier, according to Federal Reserve data provided by HighlineFI.

For JPMorgan Chase , service charges on deposit accounts declined 18% year-over-year, to $1.1 billion in the fourth quarter of 2010, while Wells Fargo saw a 27% year-over-year decline, to $1.0 billion in the fourth quarter of 2010.

Then in 2011, all three of the above bank holding companies saw modest year-over-year increases in service charges on deposit accounts.

Bank of America took an extra step when the "opt-in" rule went into effect, by eliminating all point-of-sale overdraft protection for debit card purchases, which a company spokesperson says "has significantly limited customers' ability to unknowingly overdraw their accounts and eliminates unexpected overdraft fees on these transactions."

For ATM transactions that could cause an overdraft, Bank of America says "we alert customers in advance that a transaction might cause an overdraft and result in a fee, and the customer can choose whether or not to proceed with the transaction."

The CFPB is also focusing on the order in which banks process checks and other transactions, saying that it is concerned with the practice of "commingling of all checks, bill payments, debit card transactions, and ATM withdrawals each day and processing the largest transactions first," which "maximizes the number of transactions that will trigger an overdraft fee."

Bank of America in November settled a class action suit over this very issue, agreeing to pay $410 million to 13.2 million customers whose debit card overdraft fees had been maximized, when the bank processed larger transactions first.

Frank A. Mayer -- a partner in the Financial Services Practice Group of Pepper Hamilton LLP, in the firm's Philadelphia office -- says that the Bureau has released "short-term small-dollar lending examination procedures," as a compliment to a "major initiative going on between the Federal Trade Commission, the Justice Department and the Federal Deposit Insurance Corp.," to address overdraft processing, since many smaller community banks use third-party processors, which are at times "operating in a fraudulent manner, with out clear authority from the consumer" to process transactions in a way that maximizes overdraft fees.

With the Durbin Amendment being implemented by the Federal Reserve in the fourth quarter of last year, banks took another huge hit to revenue, to the point where banks are seriously reconsidering their "free checking" business model.

Leaving Durbin aside, the CFPB took over the Fed's responsibility for the new overdraft rules last July, and is in a very powerful position to many ways, beyond just improving financial service providers' disclosures to consumers.

Mayer calls the Consumer Financial Protection Bureau "a focused cop on the beat with very significant funding," which happens to be 12% of the Federal Reserve budget.

"The Bureau is now having almost exclusive jurisdiction" for consumer matters relating to financial services, Mayer says, assuming oversight from banking regulators over "financial privacy and consumer protection," and in addition, "they are authorized to go after non-bank entities."

Last week the Bureau proposed rules to "supervise larger participants in consumer debt collection and consumer reporting markets."

FBR analyst Miller says that with the opt-in rules and Durbin, "debit cards at Bank of America are probably not profitable right now, and they need to figure out a way to charge for them, in a way that doesn't have a big headline and people rioting in the streets," as they came close to doing, when the company tried to institute a $5 monthly fee for debit card privileges, last year.

Regarding overdraft protection, Miller says that the banks "are still making decent profits for overdrafts, although they are changing their policies," and "will come under an extreme amount of pressure, making it more difficult to profit off of these."

Guggenheim Securities analyst Marty Mosby believes that banks need to evolve away from the free checking model -- which often involved just one customer relationship -- to a more complex model, where free checking will only be available to customers who "have made the bank their primary relationship, as evidenced by higher balances, and multiple products."

"What banks are doing, is saying you will have an annual fee, or we will have you pay for checks, or find other little things that were free before, if you don't have a certain amount of products or a certain amount of balances," says Mosby, who adds that the number of "relationships that each household has with banks is going to go down, as they concentrate their relationships to avoid fees," which "raises the average relationship per households, removes one-product households, and creates inertia, to make it even harder to change banks."

This "inertia" could make it much harder for up-and-coming players to grab new (and noninterest-bearing) checking account deposits, slowing their expansion, and their profits, and adding more fuel to fire of banking industry consolidation.

-- Written by Philip van Doorn in Jupiter, Fla.

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